| 04 February 2008
The evidence is overwhelming and incontrovertible. Index funds are a better way to invest than actively managed funds.
When I began giving investment advice to individuals over eleven years ago I recommended a few index funds, but the bulk of the portfolios that I designed were comprised of actively managed funds. Now, I recommend index funds (and exchange traded funds which are like index funds) almost exclusively. The main exception is when there is no index fund for a particular asset category, such as inflation protected government bonds. In that case, a well-managed low-cost fund will do the trick.
An index fund – rather than trying to beat the market – simply attempts to match the market return by holding a representative sample of all the securities in a particular sector. For example, the Vanguard Total Stock Market Index Fund essentially owns all publicly traded companies in the U.S. Similarly, the Vanguard International Stock Index Fund owns all of the stocks of the major developed markets overseas. There are also index funds covering small cap stocks, emerging market stocks, investment grade bonds and real estate. Thus, putting just a few of these funds together in a portfolio allows you to own the entire stock, bond and real estate markets – giving you a globally diversified portfolio that is easy to build and maintain.
What makes this “passive” or “market-matching” strategy so effective is the extreme low cost. The operating expenses of index funds are as low as one-tenth of 1%, which is a fraction of the cost of even the lowest cost managed funds. They are also more tax efficient because the securities are not frequently bought or sold which causes taxable gains to be realized. Further, you know exactly what you are getting and don’t have to worry about the manager leaving, changing strategies or chasing returns by taking on extra risk. In fact, you don’t have to be concerned about performance at all. A fund might perform poorly, or even lose money, if the entire market segment struggles, but you don’t have to worry about your fund manager making mistakes.
My conversion to index funds has been an evolutionary process. Over the last few years I have read numerous books and research studies by some of the top minds in the investment world. The following are my conclusions.
* A low-cost index fund will always beat over 50% of all actively managed funds. This is a mathematical certainty because investing is a zero sum game, but after deducting expenses, index funds constantly appear in the top half of performance lists.
* A low-cost index fund will likely beat over 80% of all other funds with the same benchmark target over an extended period of time. This applies to all types of index funds: large cap, small cap, value, growth, and international stocks – and especially bonds – because of the decided cost advantage.
* While a small percentage of managers will beat the index for a given time period it is impossible to identify them consistently in advance. Why spend the time, energy and costs trying to do the impossible?
* A self-directed portfolio of index funds and exchange traded funds will likely beat 90% of all other investors with a similar risk profile because many investors add another layer of fees by either paying commissions to buy funds or by hiring a full-time portfolio manager. A portfolio of index funds can be established for a negligible cost and the ongoing maintenance expenses are minimal.
* The cost of not using this strategy is tremendous. The typical advisor recommended portfolio will under-perform the comparable indexed portfolio by at least 2% because of embedded costs. A portfolio of $100,000 would grow to about $465,000 over 20 years if invested at 8%. However, earning just a 6% return by losing 2% to excessive costs and the portfolio would total about $320,000, a loss of $145,000!
Why aren’t more people embracing this market-matching strategy? First of all, many people are – at least in part. The Vanguard Index 500 Fund is now the largest mutual fund, and about 40% of pension plans are indexed. Nevertheless, too many people are not aware of this methodology, and the reason is clear. Wall Street is a multi-billion dollar industry that has a vested interest in maintaining the status quo. The large brokerage houses, mutual fund companies, independent advisors, hedge funds, private equity managers, newsletter writers and infomercial purveyors spend billions of dollars per year marketing the notion that they can help you beat the market.
They are aided in this effort by the financial media which can’t make money talking and writing about boring index funds. Instead, they air shows like Jim Cramer’s Mad Money, which might be entertaining to watch, but probably does more harm than good to viewer pocketbooks.
The prevailing myth is that you can follow a path to riches by finding an investment guru or uncovering a sure-fire strategy to beat the market. Many of the smartest people in the business have debunked this myth, while the real gurus like Warren Buffet, Jack Bogle and Charles Schwab (the person not the company) have trumpeted the virtues of index investing.
The financial markets are going to do what they do, so it is critical for investors to manage the things within our control. The greatest impact on portfolio performance derives from the asset allocation and keeping costs and taxes as low as possible – which are things we can control. Accordingly, investing is one of the few areas in life where an amateur can outperform the professionals because index funds allow us to accomplish these objectives. If you want to be a successful investor, don’t invest like a pro – use index funds instead.
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